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Europe gets serious about CO2 trading

In December 2002, the EU agreed on an emissions trading directive. If Europe’s Parliament approves it, emissions trading will start in 2005. Preparation is vital for success in this new market.

Emissions Trading
Dr. Birgit Fratzke-Weiss, Jochen Hauff A.T. Kearney,
Stuttgart/Berlin, Germany

The Council of Minister’s decision of December 2002 laid down the cornerstones of the EU emissions trading system. Since then, national authorities across Europe work feverishly to flesh out this framework with national legislation. As the second reading in the European Parliament is still pending, some details of the draft directive are subject to change.

The EU draft directive stipulates that the greenhouse gas emissions trading system will be implemented in two obligation periods, 2005-2007 and 2008-2012. Committed are combustion installations with 20 MW thermal input, mineral oil refineries, coke ovens, metal production and processing, cement, glass and ceramics, pulp and paper. Around 46 per cent of the projected EU CO2 emissions in 2010 are covered.

Figure 1. Controversial issues in the discussion on the directive on emissions trading
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Member states can exempt installations or entire sectors from participation only during the 2005-2007. However, such an exception requires proof of other emission reduction measures being conducted at exempted installations and does exempt from documentation and reporting obligations under the trading system.

As of 1 January 2005 each installation receives emission allowances for an absolute volume of CO2 from its national authorities. These allowances are tradable. If a plant emits less CO2 than it holds allowances, excess allowances can be sold bilaterally or at an organized exchange. If its CO2 emissions are higher the operator can purchase the needed quantity of CO2 emission allowances. At the end of an obligation period, allowances for each t of CO2 emitted must be provided. If a company fails to do so, a penalty of g40 for each t in the first and g100 in the second obligation period is levied. Also, the company must subsequently purchase the missing allowances.

National provisions will be vital for each company’s starting situation. Member states have some leeway in defining the National Allocation Plans (NAPs), which can have a major impact on company profitability.

Each member state must submit a NAP to the European Commission by March 31 2004, which stipulates a) the total quantity of allowances and b) the initial allocation to each sector and installation during the first obligation period. Basis for the installation-based allocation can be historical emissions, anticipated emissions and the technical mitigation potential of plants, e.g. determined based on benchmarks. Allocation can be 100 per cent free of charge in the first obligation period (grandfathering) and for at least 90 per cent in the second period. In principle, allowances rights will be issued and controlled based on installations. Member states, however, can grant operators the right to pool emission allowances voluntarily. They can also permit operators to transfer unused allowances to the next obligation period.

Figure 2. Price expectations for CO2 allowances
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The second reading by the European Parliament might still bring changes to certain key details. Jorge Moreira da Silva, reporter on emissions trading in parliament, announced that consensus will be difficult. Some points are particularly relevant:

  • Allocation: The EP would like member states to sell up to 15 per cent of the allowances in an auction rather than distributing them for free. This would give an early indication of the market price for allowances.
  • Project-based emission reductions: the Commission’s intention is that credits earned from joint implementation or clean development mechanism projects should be included as of 2005. According to the EP, they should be included starting in 2008 because efforts to reduce emissions should initially take place within the EU. A delay would block cost efficient emission reductions in the first obligation period.
  • Opt-out/Opt-in: The commission’s recommendation is that member states can withdraw industries, plants and activities from emissions trading in the first obligation period.

Risks and opportunities

Power generators are hit hard by emissions trading because they account for approximately 33 per cent of the CO2 emissions in the EU. Out of a EU-wide total of about 3.3 billion t of CO2 emissions in 2000 this amounts to around one billion t each year. Assuming an allowance price of g10/t, a financial value of around g10 billion is allocated to the sector in the form of allowances. This significant market dimension brings risks as well as opportunities for companies.

Allowance prices will determine how significant the non-fulfillment of emission targets impacts a company. For example: an efficient hard coal power plant with historical average CO2 emissions of 2.3 million t annually, could receive 2.3 million free allowances. If the plant exceeds the granted allowance volume by only five per cent due increased demand, 115 000 additional allowances must be acquired. An assumed price of g10 per allowance leads to additional costs of g1.15 million. Or double that, if the price is g20/t. Uncertainty concerning the price level is thus a real challenge to power companies.

The wide ranges of published estimates and reported prices e.g. from the UK emissions trading system offer only little orientation. Reasons for the prevailing uncertainty are:

1) the unknown quantity of allowances, which will be allocated by national governments and the share which will be free, 2) a lack of transparent information concerning the marginal cost curves of emission mitigation across trading participants, 3) uncertainty concerning transaction costs as the market is only developing, 4) the unclear structure of the trading scheme itself, in particular regarding the inclusion of project-based mechanisms.

Data quality risks add to such price risks. Availability and trustworthiness of historical emission data influence a company’s starting situation. Future emissions metering and reporting must be verifiable and correct, as even small errors can have significant financial impacts. Investment risks are increasing as CO2 emissions trading massively influences the comparative benefits of different power plant types. Due to a higher emissions intensity of brown and hard coal, their generation costs increase relatively stronger than that of gas-fired capacity. The long-term competitive positioning of brown and hard coal as opposed to gas-fired generation slips drastically, the higher the allowance price. Price uncertainties can thus lead to stranded costs for recent investments made in state-of-the-art coal-fired power plants.

Rewards for “early action” can be reaped by companies that had already initiated emission reduction measures over the past few years, if free allowances are based on historical emissions under the NAP of their country. The prerequisite to selling such excess allowances, however, is that both the reductions as well as the historical CO2 emissions were documented.

New fields of business might become an opportunity in particular for larger utilities, which could offer allowance trading services as an additional product to their clientele of industrial energy users. Many industrial operators, which are obliged to participate in allowance trading, will want to outsource trading activities as the relative size of their emissions does not justify the cost of building up know-how and processes. An optimized investment portfolio can result from reassessment of investments in new technologies and locations. As emission reductions in Eastern Europe are comparatively cheap, existing and planned engagements in these countries gains in attractiveness and needs to be examined under an emissions trading angle as well. Similarly, gas fired generation and renewable energies gain relatively to coal fired capacities.

Company action

Risks and opportunities of emissions trading call for a spectrum of measures by affected companies. Most of the issues to be addressed are not fundamentally new to power generators. But they need to be implemented swiftly and thoroughly, to be well prepared for the start of emissions trading.

A strategy for climate protection/ emissions trading is the core component of preparing for emissions trading. It needs to be based on a good understanding of the actual and projected emissions situation, cost of available mitigation options as well as an allowance market analysis. Companies can then decide how offensively or defensively they want to approach emissions trading and which processes and skills they need to develop. Until the final approval of the EU directive and due to the member states’ room to maneuver, companies can also still influence the setup of the trading system to improve their starting position. Obviously, lobbying should be in accordance with the developed strategy.

Success factors

The foundation for a successful integration is a solid fact base. The emission situation of the own company, marginal costs for CO2 abatement and costs of prevention options must be transparent. Much of the essential know-how for mitigating risks and developing opportunities of emissions trading this is already available in most companies. Irrespective of possible adjustments to the current draft directive, it is an urgent “to do” for power generators to use the time left to gain a good starting position for the begin of the trade in 2005.

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